Enhanced Financial Reporting for State Government

April 2009

Oklahoma Council of Public Affairs

“I think it an object of great importance, to be kept in view and to be undertaken at a fit season, to simplify our system of finance, and bring it within the comprehension of every member of Congress. … [W]e might hope to see the finances of the Union as clear and intelligible as a merchant’s books, so that every member of Congress, and every man of any mind in the Union, should be able to comprehend them, to investigate abuses, and consequently to control them.”

—President Thomas Jefferson, in a letter to Treasury Secretary Albert Gallatin, April 1, 1802

Introduction We are flying in stormy weather and we are flying blind.

A financial hurricane is building. It is bigger than the current financial crisis launched by the sub-prime lending debacle. It is bigger than anything that has previously hit the federal government. It is poised to unleash budget difficulties of immense dimensions.

We are flying blind because we do not understand our financial position or what it costs the government to deliver various services. Some may have a sense that government spends “too much” money, but we do not know how much government programs really cost, and we rarely measure the benefits received.

The traditional methods used to measure cost are methods that would land the CEO and CFO of any public company in prison. Some things are left off the books, especially unpleasant liabilities.

In addition, current financial reporting groups costs in ways that mask the true cost of providing services.

The purpose of this study is to illustrate an alternative way state government could report its financial position and the costs of its operations.

By coupling the approach outlined in this report with meaningful reporting on the value produced by government services, a valuable analytical tool will emerge. Better decisions about how to allocate our resources and whether to increase or decrease use of those resources should result.

The illustration of how a state government can report its costs to the public also sets an example for the federal government. We can improve our understanding of the nature of the problems we face and better equip ourselves to develop workable solutions.

The illustrative financial statements in this report attempt to demonstrate how financial statements that focus on cost might appear, and how they can provide critical information not readily available from existing financial state-

ments. They also may give important context to information that can be gleaned from existing transparency initiatives.

The illustrative financial statements are not prepared in accordance with generally accepted accounting principles but are prepared to illustrate how those principles might be more useful to interested readers seeking an improved understanding of government performance. The illustrative financial statements have not been audited, nor are they based on audited information. These financial statements illustrate an alternative method of presentation of the financial position and results of operations of the State of Oklahoma.

If the statements were prepared with the precision required to withstand an audit, it would require a far more exhaustive effort than attempted by this study. Many of the amounts presented would doubtless change, and some of them almost certainly by amounts material to the financial statements as a whole.

We cannot prosper without change The United States faces a financial crisis, a crisis that without action is likely to overwhelm us in the next quarter century and change forever the American experience. Without significant change, our current economic system cannot survive. While isolated voices have warned of this impending fiscal disaster, most observers and policymakers remain fixated on increasingly obsolete and irrelevant measures of our national debt and the value and burden created by government activity.

For several decades, most Americans have anticipated a retirement in which they would receive a government-funded pension and government assistance in meeting their health care bills. To receive these benefits, Americans have paid into the system. For most people, the amount the federal government 2

value of $1.6 trillion in federal assets. takes in payroll taxes for Social Security and However, what is not considered in any of these Medicare exceeds the amount taken for income calculations is the net present deficit of $45 trillion taxes. While many observers bemoan the lack of for Social Security and Medicare benefits. Adding prudent retirement planning by those approachall this together, our national debt is really closer ing retirement, most of those who did plan have to $54 trillion than $5 trillion. Most informed anticipated getting some retirement income from observers believe that the paltry $5 trillion is a Social Security and help with medical bills from matter of very serious national concern that could Medicare. threaten the nation’s future prosperity. And yet, in However, in 2007, Medicare Part A benefit these serious and supposedly informed discussions, payments began exceeding the program’s tax over 90 percent of the problem gets ignored. receipts. By 2019, the U.S. Treasury projects that Medicare Part A Trust Fund assets will be insuffiWhy are we so ill-informed and why don’t we act? cient to pay full benefits. The Treasury also While accounting rules themselves cannot projects that in 2017, Social Security benefit change policy, perhaps policymakers would be payments will begin to exceed the program’s tax more restrained in enactrevenues, and that by ing new benefits or more 2041, the Social Security Oklahoma was a leader in the active in assuring those Trust Fund will not have transparency movement, and the state benefits are adequately enough assets to pay full is one of the first to maintain a funded if voters were benefits.1 transparency website. This study was more cognizant of the undertaken with a view to enhancing real numbers. Many Poor accounting and the benefits of transparency. citizens may have a financial reporting vague idea that somepractices helped cause thing isn’t right with respect to federal retirement our problems programs, but, unfortunately, leaders in neither Not only have government accounting stanthe executive nor legislative branches have dards played a role in masking our problems, but sought to consistently focus attention on this failure to insist on proper accounting and reportproblem. ing has facilitated this looming crisis. For exWhile poor accounting standards may have ample, when we speak of the national debt, we facilitated the looming crisis, improved accountgenerally mean only the cash borrowings of the ing standards, and the good information those U.S. Government. Other liabilities are not considstandards will bring about, can play an important ered, such as amounts due to military veterans role in mitigating the consequences of our inaction. and federal civilian government retirees for We need to make good decisions, and good benefits already earned. The present value of information is necessary for good decision making.

Social Security and Medicare benefits for which current retirees think they have paid, and upon which they are relying, usually escapes notice.

Focus on the state level While the overwhelming nature of our problems There are assets, such as infrastructure and at the federal level appears to make most of the parks, that offset some of these liabilities. Unfortunately, the magnitude of the liabilities dwarfs the financial issues at the state level seem immaterial, state governments are not without their own value of any offsetting assets. problems to which deficient accounting standards At September 30, 2007, federal debt held by the have contributed. Oklahoma’s teacher retirement public, what commentators usually mean when system is seriously underfunded. The budgetary they refer to the national debt, totaled approximately $5.1 trillion. On the same date, the U.S. focus on available cash and the focus on the budget almost to the exclusion of other factors Treasury noted the net position of the federal often leave us without the information we need for government was a negative $9.2 trillion. The sound decision making. increase was accounted for by adding $5.7 trillion This study looks at state government accountin other liabilities, primarily unfunded pension ing practices and proposes major changes. It benefits earned by service veterans and civilian recommends that financial statements use cost as federal employees, and subtracting the book 3

the principal measurement focus and demonstrates how the provision of state services looks in this new light. In order to show how this can be accomplished, the study provides an illustration of full accrual basis financial statements for the State of Oklahoma. However, the principles developed and illustrated here are also applicable to U.S. Government finances.

providing information about the quality and scope of government services and the cost of providing them. In this way, financial statements will help citizens hold elected officials accountable. Those officials may find “internal use” financial reports helpful in carrying out their responsibilities, but such reports stop short of providing the public with the information to which it is entitled.

Several years ago a client who was a state official asked me to explain why following generally accepted accounting principles was a good thing. The audience was the chief of staff for a governor to whom my client reported.

I explained how good financial reporting could help the governor sell his program by giving the public more understandable information. I pointed out that the governor could better rally public support if voters had a clearer understanding of the problems the governor faced. I showed how generally accepted accounting principles, or GAAP, give the public a better understanding of the real situation. The chief of staff then looked at me incredulously and asked, “Who would want to do a stupid thing like that?!”

The experience drove home to me that not all government leaders want the public to understand. Some are quite happy to obfuscate the facts for their own ends. If we design accounting standards that only serve the needs of elected officials, we stop short of providing the type of information that can be helpful in a republic. The information we should communicate is: What are we doing? What are the results? What is the cost?

There are many key issues we must address in order to move from an accounting system that focuses on the budget and compliance to one that focuses on cost and value added. The next section discusses some of these issues.

The accounting profession has made significant progress over the last quarter century in improving accounting standards for government.

The formation of the Governmental Accounting Standards Board (GASB) and its acceptance as a standard-setter by members of the American Institute of Certified Public Accountants (AICPA) were important steps. GASB’s adoption of Statement 34 in June 1999, which brought true accrual accounting to entity-wide financial statements for the first time, was also a very significant milestone.

At the same time, the profession, led by the Government Finance Officers Association (GFOA), has worked to improve the professionalism of

A brief political background This study is about accounting and finance.

The purpose of an accounting and reporting system is to communicate useful information. An approach to governmental accounting that conflicts with American values would be worth little.

While this is not an exercise in political science, it may help to look at some of the unique features of our political system and make certain the accounting methods are consistent with those features.

The American system of government ushered in the concept of government by the consent of the governed. This differed significantly from Europe, where the elites, not the people, made the decisions.

Many Europeans came to America to escape the European system, and certainly the thinking of the framers of our Constitution was infused with the philosophy of men acting freely under the law and the supremacy of individual rights.

What might this mean for accounting standards? We should recognize that our reports are not so much to inform the political leaders about the bureaucracy, but to hold the political leaders accountable to the citizens who elect them. We are not ultimately governed by elites. We ultimately govern ourselves and delegate authority to elected officials to make policy and administer the government. We reserve the right to change or withdraw that delegation at the next election.

What is the purpose of government? Government is not a business. It does not exist to make a profit. In America, government exists to provide services to its citizens. This should have profound implications for accounting theory. A government’s financial reporting should not revolve around comparing income and expense as in business. Neither should it revolve around reporting if the bureaucracy complied with the law and the budget. Such reporting stops short of holding the whole government accountable.

If the citizens ultimately control the government and the purpose of the government is to provide services, then financial reporting should focus on 4

those charged with accounting matters in governeliminated. This provides a much clearer picture ment. While technically a separate issue from the of overall operations. The illustrative financial debate over accrual accounting, GFOA’s success statements that accompany this report follow this in asserting the need for professional accountants principle and consolidate operations. has had the desirable effect of recognizing a basic tenet of a profession in government, namely Government should have a balance sheet that the public interest comes first. This recogniIn the past it could be said the balance sheet tion reinforces the arguments to be made for for a government entity was a place to store data improved financial reporting that serves those to needed to keep the statement of revenue and whom government is accountable. expenditure in balance. The balance sheet proHowever, much of financial reporting by govvided little enlightening information, even to those ernment remains mired in outmoded practices generally knowledgeable about governmental that obscure the real cost of providing services. accounting.

Rather than focusing on cost, the standards by The role of the balance sheet is further diminwhich fund-level financial statements are prepared ished by the reluctance of political leaders to look continue to focus on complibeyond the next election. ance, especially compliance Many elected officials feel The traditional methods used to with the adopted budget. compelled to perform now measure the cost of government and let the future take care are methods that would land Government should report of itself. Of course, those the CEO and CFO of any public on a consolidated basis elected officials may be company in prison.

Traditionally, governments replaced, but the citizens have prepared stand-alone financial statements for various activities and then combined those financial statements into a comprehensive report. Of course, one might accurately think such a report would be confusing and misleading. Government financial statements, even when properly prepared, are almost always confusing and sometimes even misleading.

In the United States, governments at all levels are established by the consent of the governed through elections and the delegation of power to those elected. Financial reporting should follow this model. Those activities undertaken by elected officials should govern both the focus and scope of the financial statements.

Existing GAAP consider many factors in determining whether to include an activity in a government financial report. These factors include not only the ability of officials to control operations, but the degree of responsibility of the government for the debt and the financial transactions of the activity. However, financial reporting should focus on the extent to which the government exercises its power directly. If elected officials appoint an agency’s governing board, that agency is part of the government entity. No other questions need be asked.

Of course, in the private sector, the subsidiaries of a parent company are consolidated and the effect of transactions between subsidiaries is

still have their government and must depend on it for essential services.

Citizens must also ultimately pay the bills, so if the government is running up liabilities, the government’s political leaders have a responsibility to inform their constituents.

Assets Assets can provide services. Assets not only include buildings and equipment, but roads and other infrastructure improvements, such as habitat restoration at state parks or preservation of historical sites. Of course, financial assets can help cover costs when they are liquidated. However, non-financial assets may also help cover unexpected shortfalls. When Orange County, California, worked its way out of bankruptcy in 1995, the sale of the County’s landfill was the central ingredient that allowed the County to repay creditors without raising taxes or eliminating essential services.

At the same time, interested observers may ask if a government’s assets could do more good in private hands. Some land might be developed by private investors that could create jobs and bolster tax revenues. A private entity may be able to more effectively provide resources to achieve a public goal than the government itself. These instances call for privatizing a government asset or forming a public-private partnership.

5

Assets are important in government, and the financial statements should disclose the assets the government owns and their value.

where the government encourages participation in certain activities in return for future benefits. For instance, Oklahoma promises a college scholarship to a student who satisfactorily completes a Liabilities more rigorous high school curriculum and meets Under traditional government accounting rules, certain other requirements. Traditionally, the state officials could provide services and delay paying has not booked the value of the scholarships for them by incurring liabilities. For instance, earned because the state can change the prolegislators might reward state employees with gram. It is also true that the student may have more generous pension benefits while failing to acted in his or her own best interest in pursuing a currently fund those benefits. The employees may more rigorous course of study. be happy. Those who receive the services the However, the state also benefits. Students who employees provide may be happy. The taxpayers, enter college having completed more demanding who see an increase in services without higher classes in high school are more likely to succeed taxes, may also be happy. Everyone may be in college without the need for costly remedial happy, at least in the short run. classes. In addition, in order to participate, However, future taxpayers who get stuck with students, and their families often make sacrifices the bill for services they would not otherwise already provided may be make.

Not all government leaders want the less enthusiastic. LikeAccordingly, the state public to understand.

Some are quite wise, future employees should record a liability. who may be called upon The student reasonably happy to obfuscate the facts for their to make more onerous believes he or she is own ends. If we design accounting contributions to pension earning the right to a standards that only serve the needs of plans without a correfuture benefit by his or elected officials, we stop short of sponding increase in their her actions. If the state providing the type of information that benefits may also be less fails to provide the benefit, can be helpful in a republic. supportive. it breaks an implicit Just like a business, a agreement with the government should disclose on its balance sheet student. all the liabilities it has incurred. Some may In the case of some pension plans, officials complain that a liability may not have to be met if may argue that recording a liability is unnecespolicy is changed at a future date. However, a sary because the government is not going to more reasonable approach is to book the liability change the plan; that is, the plan will continue in when it is incurred and remove it if the government perpetuity. However, as we have seen, forces are changes the policy. at work that will certainly challenge the structure We should also distinguish between entitleof government as we have known it since the ments and liabilities. They are not the same thing.

Great Depression. Increasingly, governments are Someone may be entitled to a benefit because looking to the private sector to carry out functions they meet certain conditions. Most welfare and once thought the exclusive domain of government. social service programs are entitlements. If Most politicians want to act in ways that show someone meets the current definition of eligibility they can accomplish things. Building things and for, say, food stamps, that person gets food starting things attract favorable attention. Mainstamps. However, this is not a liability unless the taining them and paying for them often get far individual earns the benefit. less attention. As a result, there is a tendency to For instance, an employee provides services on build new roads and new parks, even if we are behalf of the government and, as part of compennot doing adequate maintenance on those we sation, gets credit toward a pension. The emalready have. ployee is not only entitled to a paycheck, but the While proper accounting cannot eliminate this employee has also earned a pension. Therefore, a tendency, it can bolster the cause of those who liability exists. want to expand programs responsibly while A somewhat more difficult situation may exist pointing out the true cost of operations. Likewise, 6

when pension benefits are increased, the present value of the future cost of that increase should be recognized immediately.

A similar issue exists with reporting investment earnings. Most government pension plans are defined benefit plans. In order to pay benefits, governments set up pension trust funds to which they regularly make contributions so that the trust may invest the money and, hopefully, earn a return that can help offset the government’s eventual obligation.

Unfortunately, there is no guarantee that the trust will earn a profit in any year, or even any series of years. When the government offers a defined benefit plan, the government is assuming all the risk. If the government’s investment portfolio declines in value, the government should immediately recognize the loss.

Conversely, if the government earns superior returns on the investment of its pension assets, it is the primary beneficiary. The government may reduce the size of its future contributions to the pension trust. In extreme cases, the government may even take funds from the pension plan and use those funds for other purposes.

Of course, groups representing government employees and retirees want it both ways. They want the government to guarantee the pension and use any profits only to pay better benefits.

However, the purpose of good financial reporting is not to obtain a particular political outcome (and a conflict between an employee interest group and taxpayers is always a political contest), but to make sure that the parties, and especially the public, to whom the political leaders are responsible, get all the facts in an intelligible manner.

Financial statements should inform the public about the type and extent of the government’s assets and liabilities. The illustrative financial statements for the State of Oklahoma for June 30, 2008, demonstrate how this can be accomplished.

activities. Political interest groups compete for their share of the pie. In the debate, a necessary part of our system, the parties often refer to the amount of an appropriation as the cost of the service. While they may make statements with good motives, statements that equate appropriations or expenditures with expense are misleading.

We have already seen that political leaders, seeking to minimize the impact of the costs their actions impose, will naturally attempt to finance programs with future, rather than current, revenues. This reduces the need for current appropriations and reduces the apparent cost of the service the politician is championing.

There remain other techniques for passing costs on to future legislatures.

First, the legislature may vote a pay raise that takes effect on the last month of the coming fiscal year. (Yes, this has happened in recent years in Oklahoma.) The sitting legislators get credit for increasing pay levels, although the benefit is delayed by 11 months. However, the cost is not recognized and the legislature may adjourn having balanced the budget. Of course, the next legislature has the option of reducing pay levels, but this is a highly unpleasant action that wins few votes at the next election.

The notes should disclose any unusual timing in the initiation of new pay or benefits. GAAP currently require the disclosure of significant subsequent events, such as the issuance of new bonds after the end of the fiscal year. We should require similar disclosure of actions that, if not reversed, will increase costs for existing programs in future years. The illustrative financial statements in this report contain no such disclosure because the legislature did not employ this technique in the year ended June 30, 2008.

Proponents of increased government spending will point out that the timing of tax cuts usually means that only a portion of any revenue loss is budgeted in the year the tax cut takes effect.

Oklahoma is on a fiscal year ending June 30.

However, most taxpayers compute their taxes on the basis of a calendar year. This leaves a sixmonth differential.

A tax reduction passed by the Oklahoma legislature normally takes effect the following January 1. The tax rates don’t change during the first half of the fiscal year for which the tax cut was budgeted. In addition, most withholding is paid monthly in the following month, so the

Reporting the real cost of government services Corresponding to the premise that the financial statements should report liabilities for all costs already incurred, the financial statements should also reflect the actual cost of providing government services. In technical accounting terms, this means reporting expense rather than reporting expenditures.

In preparing a budget, a legislative body allocates available financial resources to various 7

standard convention is to budget five-twelfths of decay reaches a crisis stage. any expected revenue reduction from a tax cut in The notes to the financial statements should the coming year because tax collections for the probably contain a disclosure of estimated mainfirst seven months of the fiscal year will be on the tenance in coming years. The illustrative financial basis of tax rates in effect before the tax cut goes statements accompanying this report do not into effect. include such a disclosure as I am not clear on Of course, many proponents of bigger governwhat would be best. While legislators have agenment often ignore the feedback effect that a tax das, so do bureaucrats, even those with good cut, especially a reduction in tax rates on work intentions. Just as the politically oriented legislaand investment, has on revenue. A 10 percent cut tor likes the photo-ops that go with the dedication in income tax rates will result in less than a 10 of new facilities, the bureaucrat wants to encourpercent reduction in tax revenues while a 10 age increased appropriations and security for his percent increase in rates is unlikely to generate a or her operations.

10 percent revenue gain. I have watched many As a result, I am not confident in recommendvery knowledgeable observers get surprised by ing a particular manner of disclosure. However, the less than expected impact of a tax rate reducfuture efforts similar to this project should contion and disappointed by the ability of a tax hike sider including disclosure of the extent of deferred to raise revenue.2 maintenance and the reliabilHowever, the point of ity of the deferred mainteThe information we should nance estimates. proponents of more spending communicate is: What are we and higher taxes is well doing? What are the results? taken. The financial stateThe cost of programs inWhat is the cost? ments should disclose all cludes overhead material policy changes to People realize that a private company, in addition to making a product, take effect in future years that will impact the state’s finances. must spend resources to sell the product and A second technique for reducing the appropriamake collections on its sales. It must also keep its tion necessary to carry out operations is to defer books current, arrange for its finances, and effectively hire, evaluate, and retain its personnel. maintenance. If the state builds a new road, political leaders and dignitaries will gather to cut We refer to such activities as overhead. a ribbon and engage in general hoopla. When a Yet, in government, we tend to think of such state worker patches a pothole, repairs a guardactivities as freestanding when their real purpose is to help other agencies achieve the other agenrail, or cuts weeds from the shoulder, the result is no hoopla and few opportunities for political cies’ objectives. A private business must pay its employees and collect its receivables. We recogplaudits for the elected officials. nize this overhead as part of the cost of doing This state of affairs has several effects. First, we business. tend to build things we can’t properly maintain.

Professional engineers are constantly bemoaning However, we seldom attribute the cost of the Tax Commission to the agencies and programs the lack of upkeep on our roads. When serving as state finance director, I more than once visited they serve by collecting revenues. The same is state parks and other facilities where maintetrue for other overhead functions such as those carried out by the Treasurer, the Auditor and nance was neglected. In one instance, the neglected facility was an old building caring for Inspector, the Office of State Finance, the Departsome of Oklahoma’s most vulnerable citizens. ment of Central Services, and the Office of Personnel Management.

I have also heard legislators plead for new or expanded park facilities, usually in their districts, Accordingly, the illustrative financial statements do not treat overhead functions as separate while simple upkeep was neglected at existing parks. A legislator appears to be getting someactivities, but allocate the cost of overhead functions to the programs their actions assist or thing done for constituents by building a new golf course. The cameras show up for positive photoregulate. A part of the cost of providing preventive health services is assessing and collecting the ops. However, if a sewer lagoon needs maintenance, fixing it gets little fanfare until the lagoon’s taxes to pay for the service, hiring and processing 8

personnel to carry out the activities, and complying with the myriad of rules and regulations that attend government activities.

The illustrative financial statements account for every cost that the state incurs as part of a service the state provides to the public.

funds that may have little in common except that they are funded by dedicated revenue sources.

Rather than focusing on funds, the illustrative financial statements focus on activities and programs.

The statements provide an overview of government activities. These statements answer the question, a question that current financial reporting does not completely answer: How much do our various programs cost? The Government-wide Statement of Activities also shows the extent and the manner in which those are financed currently.

The activities of each statement are then treated separately and broken into further detail.

For instance, the Statement of Activities for Public Safety shows the cost of separate activities: • Punishing and rehabilitating adult offenders • Preventing and correcting juvenile crime • Patrolling state highways • Investigating and resolving crimes • Prosecuting crimes • Etc. The illustrative financial statements focus on the cost of providing services instead of administrative boundaries. While this adds a degree of subjective judgment, the result is reports that are more meaningful. In assigning costs to activities, an attempt was made to assign the costs to the activity that supposedly benefited from that cost.

For example, the Oklahoma Department of Career and Technology Education conducts educational programs for prison inmates. While administratively these programs are carried out by an agency primarily responsible for education, these programs are also conducted in behalf of corrections. Therefore, the costs of the programs are included in public safety, not education, reflecting the impulse behind them.

The ability to parse the data is seemingly infinite. Certainly, the state could provide another level of reporting, or even two or three more levels of additional detail, and there are instances where this would be helpful. However, our purpose here is to illustrate how the data might be presented to convey the cost of programs. It may be best to leave more detailed reporting to separate reports on the details of an activity.

What is missing are the benefits derived from the activities. In the private sector, if we know how much it costs to run the business, we also want to know how much it sold. Of course, the goal of government is not to maximize profits, but to

The truth is good, smoothing things that are not smooth is bad When managing an investment portfolio, a manager wants profits, but also stability, especially when he or she reports results. However, if the state takes responsibility for achieving a certain result, which it does when it maintains a defined-benefit pension plan, it is going to have both gains and losses to report, unless it invests so conservatively that it eliminates all risk, a strategy also likely to hold down long-term returns.

If Oklahoma loses a billion dollars on investments, as it did in the year ended June 30, 2008, the financial statements should reflect that. Of course, such disclosures may bring questions that managers and political leaders would rather not have to answer. They prefer to “smooth” results over time as a result. Rather than showing a 6 percent loss in year one and a 24 percent gain in year two, they would prefer to show a gain of 9 percent in both years.

They may argue that the financial markets are inherently volatile and that the investment objectives of a pension plan are long-term. Both assertions are true and the losses of one year can usually be recovered in future years. However, there is no guarantee. Current GAAP do not require that current gains and losses, or even the full extent of existing pension obligations, be included on the face of the financial statements. The illustrative financial statements correct this deficiency.

Organize reporting by program rather than by fund Consistent with the traditional focus of financial reporting in government on compliance, traditional statements of activity are organized by fund or fund type. All financial resources that flow through the general fund are reported in a column for the general fund. All financial resources obtained through taxes that are earmarked for a specific purpose are aggregated into another column for special revenue funds.

The value of a report on the revenues and expenditures of a special revenue fund type is dubious. It is simply an amalgamation of several 9

maximize the value of its services relative to the costs incurred. Governments should combine a report on the cost of providing services, as shown in the illustrative financial statements, with information on the value of the services provided.

The second year, the state collected two-thirds of the previous year’s taxes and two-thirds of those for the current year. There was little budgetary impact from year one to year two. The third year, the state collected one-third of the previous year’s tax and 100 percent of the current year’s. Again, there was little disturbance. However, the fourth year, the state collected all of the current year’s tax but no tax from the previous year.

Corporate income tax revenue was down significantly. Corporate income tax is one of the more volatile taxes anyway, but in this year, the normal volatility was exacerbated by faulty accounting. By accounting for income tax and other taxes at the time the underlying transaction giving rise to the tax occurs, a government will avoid surprises. Of course, this approach requires use of some estimates, but such estimates are not particularly difficult in most situations.

Achieving symmetry in society Financial reporting for government should reflect the interaction of the government with others. This happens normally in most private transactions. For instance, when business A buys something from business B, each usually records the transaction at the same time. Business B records a sale while Business A records a purchase.

Government is not always so straightforward.

It imposes taxes and then collects those taxes.

With respect especially to income taxes, there are timing differences. Consider the following.

An individual earns income. He or she has money withheld for tax purposes or pays estimated taxes to the state. After year’s end, the taxpayer prepares a return in which he or she calculates the actual tax due and pays the additional tax or files for a refund. If the individual’s income is from a sole proprietorship that prepares financial statements, the financial statements will display the estimated tax or refund due on the income earned.

However, the state does not show the additional tax to be paid on income already earned. It should. Just as the state should accrue expenses based upon its activities, it should accrue revenue based upon the activities that give rise to that revenue. This is not a major issue at this time in Oklahoma, but it could be, and the state needs to do the accounting right. By reporting revenue based upon its receipt, as is the general rule at present, the state risks a material misstatement.

I was once an advisor to a state official facing a serious unexpected budget shortfall. An examination revealed that one cause was a failure to account for changes in tax policy. This state had not required corporations to make estimated income tax payments until four years earlier.

Because of the large impact on business, the state phased in the new estimated payment requirement over three years.

The first year, the state collected all the revenue for the previous year plus one-third of the amount expected for the current year. Notice that the government created a 33 percent windfall.

A twist on the matching concept All students in an introductory accounting course learn the basic concepts that underlie accounting practice. One of those concepts is matching. Matching means that expenses should be matched with the revenue to which they give rise.

However, in government, the focus is on cost, not income, so rather than matching expense to income, the state should match its revenues to the expenses they fund. This is an issue with respect to infrastructure. States build roads with a combination of state and federal funds. The federal government makes grants to the states for road building. Generally, states should properly record revenue from a grant when it completes the requirements for receiving the grant. In the case of roads, the state will usually be able to recognize the revenue from the grant as it builds the roads.

However, a road is a capital asset that people will use for many years. The state should recognize the cost of the road over the period of its use, and the illustrative financial statements accomplish this by charging depreciation over the expected life of the road to transportation expense. However, the state has long since completed all steps necessary to assure its right to the federal grant that helped build the road.

To recognize the grant as revenue when the asset that it helped purchase is capitalized and depreciated would be misleading. Accordingly, 10

the illustrative financial statements display deferred revenue, which is then charged to expense as the state recognizes depreciation on the related roads. Of course, while we should match grant revenue with the expense it is meant to offset, we should also match the expense with the service provided. The enhancements in these financial statements accomplish that objective in the case of roads by charging expense through depreciation as the road is used.

Common school activities The proper classification of some activities is certainly open to debate. The single largest item in recent state budgets has been an appropriation for common schools (K–12). Technically, this is assistance to local governments as each school district elects its own board that exercises administrative control within the boundaries of state law.

However, the illustrative financial statements show this assistance as an education activity.

While each school district has its own elected board, the major decisions as to whom the schools must educate, the curriculum they follow, whom they may hire as teachers, and what they are paid are so heavily regulated by the state that it is a de facto state activity. The illustrative financial statements account for it as such.

When is it a tax and when is it a user fee?

In the current environment, few politicians want to be seen as favoring higher taxes. Those who do advocate higher taxes are usually very selective about those to whom the added burden will apply so that they will not be seen as advocating higher taxes for the majority It is one thing for a taxpayer of their constituents. AccordDisclosures can also be to be able to view individual ingly, many times we see helpful transactions of a state higher fees in lieu of higher The notes to the finanagency. It is another thing taxes. We also see new cial statements provide altogether to understand the taxes called fees even if the essential information to state’s financial position and person paying the fee gets assist the readers of the the cost of its activities. little directly in return. financial statements.

Oklahoma, a state with a While there are areas constitutional limit on higher where we could complain taxes without a vote of the people, increases the that the minutiae the notes often contain are more pressure on politicians to call a tax a fee. of a distraction, this project has not attempted to In the illustrative financial statements, the critique the drawing of the line between what is government-wide statement of activities limits the required and what is not. However, there are classification of user fees to something other than instances where additional disclosures may be taxes only when the fee can legitimately be called helpful. a sale. For instance, turnpike tolls and college For example, the legislature may grant favortuition are sales of government services, while able tax treatment for certain transactions it taxes on the sale of gasoline and tobacco are not. deems in the public interest. In many cases, these Sales result only from the government selling a tax preferences are granted in lieu of subsidies in service it creates and provides. an attempt to fulfill a state objective. These When the sovereign power of the state is preferences, or “tax expenditures,” have a signifiinvolved, we have a tax. The illustrative financial cant financial impact. Accordingly, the state statements do distinguish fees for professional should disclose them in its financial statements, and similar licenses, but these are, in effect, taxes and the illustrative financial statements do so. since there is no realistic alternative to the govSome object to the term tax expenditure as all ernment license. In contrast, a student may attend the government is doing is allowing someone to a private college and a motorist may travel on keep what originally belonged to them. However, roads that are not subject to tolls. In arriving at the reality of refundable credits where the credit the net cost of an activity, the illustrative financial may exceed the amount of tax otherwise due statements deduct revenue from the sale of undermines this view. Meanwhile, when a governservices and any grants and contributions from ment imposes a tax and then allows some taxpayoutsiders in determining the activity’s net burden ers to avoid paying the tax instead of reducing to taxpayers. taxes for all taxpayers, the government does 11

something comparable to spending when it grants preferences. However, the term “tax preferences” is employed to avoid a controversy not directly relevant to this project.

The state also places restrictions on who may be hired to work for a state agency and requires that certain preferences be granted to some applicants. There is often less flexibility to hire, train, and reassign staff in government. Accordingly, the number of workers approaching retirement and similar matters are disclosed because the ability of the state to attract and retain qualified staff is important to carrying out its missions.

As previously discussed, future efforts similar to this project may want to consider making disclosures about the extent of deferred maintenance.

movement, and the state is one of the first to maintain a transparency website.

This project was undertaken with a view to enhancing the benefits of transparency. It is one matter for a taxpayer to be able to view individual transactions of a state agency. It is another altogether to understand the state’s financial position and the cost of its activities.

The government should simply report: • This is what we do • This is the cost of doing it • These are the benefits provided • This is how we accomplished it Transparency provides an opportunity to investigate the last of these disclosures, how the state goes about trying to accomplish its objectives.

The illustrative financial statements show how the state could provide the first two items. If we can incorporate measures of service efforts and accomplishments into the reporting process, we will place significant tools in the hands of those who take seriously their responsibilities as citizens.

Those citizens, for the first time, will be able to understand not only what the government does, but how much it costs to do it and what the public receives as a result. Armed with this information, citizens can for the first time view the books of their government as, in Thomas Jefferson’s words, “clear and intelligible as a merchant’s books,” so that they will be able to investigate abuses and control them.

We can understand how much it costs the government to provide services. Combined with reporting on services, efforts, and accomplishments, we can see if we are getting value for our money. We will know if the government has assets to offset its liabilities. We will know if we are paying for the services we receive or if we are getting services by pushing the cost off on future generations. These are benefits our current accounting system fails to provide. If we can enlighten ourselves about our finances and get the information needed to address a serious fiscal crisis, we will make important progress. %

Financial statements should be timely Governments are notoriously tardy in publishing their financial statements. The federal government allows state and local governments up to 13 months to submit reports under the Single Audit Act. Meanwhile, the Securities and Exchange Commission allows publicly traded companies only 90 days to issue audited financial statements, and most sophisticated businesses can close their books in two or three days. Quite a discrepancy!

While some in government will blame the long time period upon the complexity of government operations, governments are no more complex than business operations of comparable size.

Most large businesses have several subsidiaries and must account for global transactions that occur in different currencies.

A more likely cause of the lack of urgency is the general lack of interest that accompanies the release of a government’s financial report. Few clamor for the data, and perhaps the reason is that they do not see the data as especially helpful as they are currently organized. And in many cases, the data are not particularly helpful.

Financial statements should be issued and audited no less than 90 days after the end of the fiscal year.

Endnotes Transparency and financial reporting Taxpayers are often frustrated by government’s seemingly unfathomable complexities. Recently, a movement toward transparency has sought to shed much-needed light on government operations. Oklahoma was a leader in the transparency

1 “The Federal Government’s Financial Health: A Citizen’s Guide to the 2007 Financial Report of the United States Government,” The Financial Management Service, A Bureau of the U.S. Department of the Treasury, page 2.

2 See also Reed, W. Robert, “The Robust Relationship Between Taxes and State Economic Growth,” The National Tax Journal, March, 2008.

12

A WORD ABOUT THE ILLUSTRATIVE FINANCIAL STATEMENTS face of the statements, such as subsequent events.

Most items covered by existing notes generally included with state government financial statements would remain under a cost-focused scenario. As such, the notes that currently appear in Oklahoma’s financial statements are referenced but not further addressed. However, there are additional disclosures that should be considered under the approach outlined in this project. These additional disclosures include a discussion of tax preferences, sometimes called “tax expenditures,” where the government grants preferential tax treatment. Additional disclosure may be helpful with regard to the government workforce as the recruitment and retention of qualified workers is often more difficult in the government environment.

The notes to Oklahoma’s financial statements are referenced below with explanations and examples where changes from the existing content are recommended. Existing GAAP may require notes that are excessively detailed beyond what is constructive. However, a critique of this practice is beyond the scope of this project.

This project focuses on the cost of government activity. Elsewhere in this report, the merit of including information about the value added by government activity, often called “service, efforts, and accomplishments reporting,” is discussed.

Including such information is beyond the scope of this project. However, financial statements that do include information about the value added by government activity should include notes relating to that information.

The illustrative financial statements that accompany this report are not prepared in accordance with generally accepted accounting principles that currently apply to government. They are prepared to illustrate how generally accepted accounting principles in government can be more useful.

The amounts shown in the illustrative financial statements are often taken from official state sources, including the state’s own comprehensive annual financial report and its OpenBooks transparency website. Other data were acquired informally from knowledgeable officials, and still other data presented were estimates prepared by me and the team that helped me complete this project.

The illustrative financial statements are shown only for the purpose of discussion about financial reporting and may not fairly present the state’s financial position or results of operations. The data have not been audited or, in some cases, even independently verified and may contain material errors and omissions.

This project presents a new approach to financial accounting for government. The project uses data for the State of Oklahoma to prepare illustrative financial statements that focus on cost and accountability of the elected government to its citizens. The notes are an integral part of the financial statements. They explain the policies used in the accounting process and provide important detail to aid the reader in understanding. The notes also provide important information that cannot be readily quantified, such as contingencies, or that would be inappropriate on the

13

ILLUSTRATIVE GOVERNMENT-WIDE FINANCIAL STATEMENTS

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Balance Sheet June 30, 2008 (in $ thousands) ASSETS Current assets Cash and equivalents Short-term investments Accounts receivable Current portion, long-term receivables Inventory Pension assets Other current assets Total Current assets Noncurrent assets Long-term investments Long-term receivables Land Construction in progress Depreciable assets, net Pension assets Assets held only as fiduciary Other noncurrent assets Total Noncurrent assets Total assets

LIABILITIES Current liabilities Accounts payable and accrued liabilities Current portion, long-term debt Current portion, pension liabilities Deferred revenue Other current liabilities Total Current liabilities

$ 6,134,672 4,617,295 1,385,986 92,108 121,092 1,651,971 28,041 14,031,165

Noncurrent liabilities Accrued liabilities not currently payable Capital lease obligations Long-term debt Pension liabilities Liability for other post employment benefits Deferred revenue Liability for assets held only as fiduciary Other noncurrent liabilities Total Noncurrent liabilities

3,794,870 1,998,465 1,824,367 811,668 10,760,363 18,706,963 482,756 428,291 38,807,743

Total liabilities

$52,838,908

EQUITY Citizen equity Total liabilities and equity

The accompanying notes are an integral part of the illustrative financial statements.

14

$ 2,041,149 514,813 1,651,971 778,025 267,923 5,253,881

799,911 174,273 7,033,369 32,880,756 283,233 4,308,281 482,756 507,134 46,469,713 51,723,594

1,115,314 $52,838,908

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense ACTIVITY Education Health and Welfare Public safety Transportation Public insurance Public utilities Assistance to local governments Natural and cultural resources General government Regulation Economic development Cost of increased pension benefits to former employees Total

$ 9,225,428 7,091,784 1,435,108 928,386 923,698 380,367 328,910 295,270 159,849 116,668 110,039

$

Total taxes

Increased / (decreased) burden to taxpayers in future years

$ (5,835,264)

2,819,364 2,069,303 1,114,950 604,926 552,193 419,617 237,166 100,778 86,648 513,020

197,617 (938,310) 41,936

Total, other revenues

Burden to taxpayers from current services less: current amount of taxes and other revenues

-

8,517,965

Other revenues Licenses and permits Income/(loss) from money and investments Fines, forfeitures and miscellaneous

Total, all sources

Net expense

$ (3,344,613) (477,099) (85,939) (307,598) (976,805) (471,253) (4,139) (84,214) (66,080) (6,513) (11,011)

376,689 $ 21,372,196

TAXES and OTHER REVENUES Taxes Individual income taxes Sales and use taxes Gross production taxes Motor vehicle taxes Corporate income taxes Fuel taxes Tobacco taxes Insurance taxes Beverage taxes Other taxes

Sales

(698,757) $

7,819,208

$

9,689,207 7,819,208

$

1,869,999

The accompanying notes are an integral part of the illustrative financial statements.

15

$ 5,880,815 6,614,685 1,349,169 620,788 (53,107) (90,886) 324,771 211,056 93,769 110,155 99,028 376,689 $15,536,932

Grants and contributions $

(770,411) (4,051,854) (303,462) (444,627) (151,868) (107,909) (5,252) (6,918) (5,424) -

$ (5,847,725)

Burden to taxpayers $ 5,110,404 2,562,831 1,045,707 176,161 (53,107) (90,886) 172,903 103,147 88,517 103,237 93,604 376,689 $ 9,689,207

N O T E S T O T H E I L LU S T R AT I V E C O S T- F O C U S E D F I N A N C I A L S TAT E M E N T S Note 1. Summary of Significant Accounting Policies The illustrative financial statements include several features that differ from existing GAAP presentation. Most of these differences are related to entity definition, measurement focus, matching, intergenerational equity, and symmetry in society.

Entity definition—The illustrative financial statements include all activities under the direction, either directly or indirectly, of officials elected by the voters of Oklahoma. This includes all activities where a board is appointed by state elected officials or by others appointed by those officials. Consistent with the fact that the state is a political unit accountable to its citizens, the financial statements report on all activity conducted by that unit on behalf of those who elected its decision makers.

As a result, the illustrative financial statements do not distinguish between general government, component units, or other relationships. If the duly elected officials of the state can ultimately direct the operations of an agency, board, commission, or public trust, it is included as part of the illustrative financial statements.

Accordingly, the illustrative financial statements recognize indirect expenses incurred for the benefit of other agencies as part of the expense of providing services through those agencies. For instance, in the illustrative financial statements, the cost of collecting taxes is allocated among all activities financed by those taxes.

The illustrative financial statements also allocate other overhead costs among the activities meant to benefit from those activities. Central fiscal operations, personnel management, central purchasing, and other general management functions are allocated to activities based upon appropriate criteria, such as expenditures, appropriations, or number of personnel. This policy is maintained even though the purpose may be to prevent misappropriation or abuse rather than benefit the activity charged directly.

The illustrative financial statements also distinguish between transfers that are truly a payment from one agency to another and transfers that are made on behalf of third parties. For instance, the Oklahoma State and Education Employees Group Insurance Board (OSEEGIB) is a state agency that provides insurance benefits to state and county employees and teachers. How-

ever, state employees are not automatically enrolled in OSEEGIB. Rather, OSEEGIB must compete with several private sector providers for the business of those it serves. The State offers its employees a choice between OSEEGIB and its competitors and withholds the cost of premiums from its employees’ pay and benefit allowances. It then transfers the funds withheld to the providers as chosen by its employees.

When the transfer is made from the State to OSEEGIB, it is treated as an arm’s length transaction rather than a transfer. The State has compensated its employees. Separately, the State, through OSEEGIB, has sold insurance to its employees.

The transfer to OSEEGIB is treated as revenue to the State, specifically a charge for service.

Special considerations arise when more than one level of government funds, manages, or delivers a service. The illustrative financial statements report the cost of programs primarily managed and delivered by the State of Oklahoma as a state activity. Funds provided by the federal government for state activities are included in grants and contributions. Funds the State provides to local governments for services primarily managed and delivered by local government are reported as assistance to local governments.

The factors considered in determining which level of government primarily manages and delivers a service include which level of government is responsible for: • determining the extent of program coverage • determining eligibility to participate by establishing rules for participation • determining eligibility to participate by applying the rules to individual situations • determining the type and level of benefits delivered • employing workers and/or contractors to deliver services including o establishing criteria for employees and contractors o establishing rules that govern the firing of employees and retaining of contractors o selecting individual employees and contractors o supervising employees and contractors Common schools are funded primarily by the State of Oklahoma, although federal assistance and local taxes are also important sources. Voters 16

local government on an ad hoc basis or where the level of funding is not significant. These situations are all treated as an expense related to a state activity, although a local government may exercise considerable control over the management and delivery of the ultimate service. Examples of such situations are found as part of the Office of Juvenile Affairs, the Oklahoma State Bureau of Investigation, the Arts Council, the Water Resources Board, the Department of Libraries, and many other agencies.

Measurement focus—The illustrative financial statements are presented using the economic resources measurement focus and the accrual basis of accounting. Consistent with the principles that follow, revenue is recognized when earned and expenses are recorded when a liability is incurred, regardless of the timing of related cash flows. Similarly, grants and similar items are recognized as revenue as soon as the State has met all eligibility requirements imposed by the provider.

Under existing GAAP, financial statements prepared at the government-wide level are prepared using the accrual basis of accounting and a measurement focus on economic resources.

However, existing GAAP use a modified accrual basis of accounting and a measurement focus on current financial resources in all general government statements below the entity level. The illustrative financial statements make no such distinction. The illustrative financial statements apply the measurement focus consistently, from the entity-wide financial statements to the more detailed activity-level statements.

The illustrative financial statements also refine the measurement focus by recognizing a liability to the State when others have taken action in good faith with a reasonable expectation of receiving a future benefit. Therefore, when the State, in an effort to achieve a public goal, offers to pay the college tuition of high school students who meet certain requirements, such as taking a more rigorous set of classes than would otherwise be required, the illustrative financial statements recognize a liability when students and their parents, in good faith, sign up for the program and begin complying with its requirements. The liability is adjusted to the extent the students are expected to complete those requirements.

Similarly, the State also recognizes the present value of pension and other post-employment benefits as a liability at the time they are earned

elect local school boards, but important decisions about who is to be educated, the amount of education services provided, the overall curriculum, and qualifications for teachers are made by the State of Oklahoma apart from local school districts. Accordingly, Oklahoma’s common schools are treated as a state function, although the financial statements do not include local tax revenues.

Similarly, the activities of the Department of Career Technology and Education, the Oklahoma Conservation Commission, and the District Attorneys Council are treated as state functions, although local districts make many decisions and provide important funding. In all cases, the purpose, scope, and rules are determined at the state level, although locally accountable officials implement the decisions made at the state level.

The illustrative financial statements do not include funds provided by local sources.

However, other county activities are not treated as state functions because the locally elected county officials exercise more decision-making control. However, the State provides major funding for many county activities. The illustrative financial statements report this financing under assistance to local governments. The major areas of assistance reported include funding for county health departments and county roads and bridges.

In addition, the State manages pension systems for firefighters and police officers. Almost all participants in both systems are local government employees. However, while both employees and employers contribute to the pension plans, the State underwrites the benefits, establishes the rules of participation, and sets the benefit determination formulas. Increases in the unfunded liability of the systems are treated as an expense of the state, while declines in the unfunded liability (or gains in surplus funding) are treated as revenue to the state.

Another area of consideration is community development. The largest program, the Community Development Block Grant, is a federally funded pass-through intended to spur local economic growth. The federal assistance is included in grants and contributions, while the grants to local governments are included in assistance to local governments. However, community development also includes funds appropriated by the state for sub-state planning districts.

There are many other instances in which a state agency will provide funds or services to a 17

by state employees. This is discussed in more detail below, under intergenerational equity.

Matching principle—The matching principle is basic to accounting and financial reporting. As generally applied in the private sector, the matching principle means expenses are recognized when the revenue to which the expenses give is recognized. Thus, expenses are matched to revenue and the financial statements give a clearer picture of the profitability.

However, government is not in business to make a profit, but to provide services for the public good. Rather than incurring expenses to produce revenue and profit, the government collects taxes and other revenues in order to fund its services. Whereas in the private sector, the desire for revenue drives the need for expense, in government, the desire to provide services drives the need for revenue.

The matching principle is relevant in government. However, rather than matching expense to revenue, the illustrative financial statements match revenue to expense. For example, when the federal government provides funds for capital improvements such as roads, the State would generally record revenue when it has met all the eligibility requirements of the grant. This would usually mean building a road in compliance with the terms of the federal assistance.

However, the road, a capital asset, will provide service to the public over many years. In the illustrative financial statements, the State recognizes the expense of providing that service through depreciation. Accordingly, the illustrative financial statements defer revenue from federal grants that help pay for road and bridge construction and recognize it over the same period that the expense of providing the public service is recognized.

The application of the matching principle is further refined by two additional principles: symmetry in society and intergenerational equity.

Symmetry in society—In the private sector, when a transaction occurs between two parties, each party will usually make corresponding accounting entries at the same time. For instance, if X sells to Y on credit, X will record a receivable and Y will record a payable at the time the sale is executed. The illustrative financial statements apply this same principle to the State’s financial statements.

When an individual or business earns income that is subject to income tax, the illustrative

financial statements recognize revenue to the State. The taxpayer would recognize an expense and a liability for any tax due at the time income is earned. Accordingly, the State recognizes revenue and a receivable at the same time, regardless of when the tax is paid or due. Similarly, sales taxes are recognized when sales subject to the tax are made, and gross production taxes are recognized when oil or gas is produced.

Intergenerational equity—Intergenerational equity measures the extent to which public officials have postponed or accelerated the incidence of cost related to program benefits. To the extent practicable, the illustrative financial statements charge the cost of actions taken by current officials to the current time period. For instance, the present value of the cost of added pension or other post-employment benefits related to services already performed is recognized when those benefits are voted in by the legislature rather than being amortized over some future period.

Note 2. Deposits and Investments No significant change is contemplated except that the effect of securities lending agreements is not displayed on the balance sheet. The note disclosures would remain as at present.

Note 3. Receivables The State has amounts due from numerous sources: taxpayers, the federal government, and those purchasing state services, etc. No change is contemplated except that income earned by taxpayers that is subject to state income tax results in the State recognizing a receivable for tax revenue at the time the taxpayer earns the income.

Note 4. Interfund Accounts and Transfers Interfund transactions and balances, including those between what is currently referred to as the primary government and component units, are eliminated. This is consistent with private sector consolidated reporting.

Note 5. Capital Assets No significant change is contemplated. However, one issue raised but not resolved by this project is the reporting of replacement cost of capital assets in use.

Note 6. Risk Management and Insurance No significant change is contemplated.

18

Note 7. Operating Lease Commitments No significant change is contemplated.

very name of the program indicates the State has obligated itself to fund the scholarships and has therefore incurred a liability.

Approximately 28,500 Oklahoma high school students are enrolled in the Oklahoma’s Promise program. The State projects the cost of tuition for the program for the current year to be $54 million.

The liability for future tuition payments for high school students enrolled in the program and for college students in the program for whom additional tuition payments beyond the current year will be made is estimated to be $313.8 million.

No other significant change is contemplated except that the illustrative financial statements would not distinguish between the obligations related to governmental activities, business-type activities, or component units.

Note 8. Lessor Agreements No significant change is contemplated. However, lease agreements between different agencies of the State of Oklahoma are consolidated.

Note 9. Long-Term Obligations Oklahoma’s Promise—The State Regents for Higher Education promote and administer a program to assist students from families with income below $50,000 to attend college in Oklahoma. To remain eligible, the student’s family income cannot exceed $100,000 in the year the student enters college. To participate, a student must apply before his or her final two years of high school. The student’s parent(s), custodian(s), or guardian(s) must agree to help the student meet the program’s requirements. The student must take a more rigorous curriculum than is generally necessary to graduate from high school according to the following schedule of required courses: 4 years of English 3 years of lab science 3 years of mathematics 3 years of history and citizenship skills 2 years of foreign language or 2 years of computer technology 1 year additional of any of the above 1 year of fine arts or speech In addition, the student must maintain a 2.5 GPA in the required courses and a cumulative 2.5 GPA for high school, abstain from abusing drugs and alcohol, abstain from criminal activity, and meet certain other requirements.

For a student who successfully completes the program, the State will pay the student’s college tuition according to schedules published by the Regents for Higher Education. The program covers only tuition and does not cover books, room and board, activities, and special fees.

Students are encouraged to apply for other financial aid for assistance with these other costs.

The statutes provide a mechanism to reduce the number of awards in the event that funding is insufficient to cover anticipated costs. However, this provision is not widely discussed in Oklahoma’s Promise promotional literature. Since students must complete actions that they might not in the absence of Oklahoma’s Promise, the

Note 10. Restatements of Balances No significant change is contemplated.

Note 11. Nonrecourse Debt and Debt Guarantees No significant change is contemplated.

Note 12. Retirement and Pension Systems No significant change is contemplated in the notes, but the full extent of the present value of pension assets and pension liabilities is reported on the balance sheet.

Note 13. Other Postemployment Benefits No significant change is contemplated in the notes, but the full extent of the present value of other postemployment benefits is reported on the balance sheet. The State does not maintain assets to offset this liability.

Note 14. On-Behalf Payments No significant change is contemplated.

Note 15. Tax Preferences The State levies taxes to finance many of its activities. As part of its system of taxation, the State grants certain tax preferences including exemptions, credits, exclusions, deferrals, preferential rates, and other provisions. In alternate years, the Oklahoma Tax Commission attempts to estimate the amount of revenue the State would have collected but for the existence of the tax preference. The tax preferences with the largest estimated impacts on revenue as calculated by the Oklahoma Tax Commission are listed below.

19

Preference Amount Sales tax on sales of items used in the manufacturing process ...................................................... $1,623,110 Sales of items for the purpose of resale .............................................................................................. $1,493,000 Use of itemized and standard deductions on individual income tax ................................................. $685,506 Use of personal exemption on individual income tax .......................................................................... $137,911 Sales tax on sales to counties, municipalities, and other local governments .................................. $104,750 Sales tax on utilities for residential use ................................................................................................... $99,592 Cigarette tax on sales to Indian tribes that have compacted with the State ...................................... $96,648 Sales tax on sales to the State of Oklahoma .......................................................................................... $85,105 Motor vehicle excise tax on used motor vehicles held for sale by dealers ......................................... $70,726 Sales tax on sales of livestock, agricultural products, and certain items used in agricultural production ................................................................................. $63,905 Prorated motor vehicle excise tax on registered trucks and trailers .................................................... $63,516 Tax on sales of prescription drugs and similar items ............................................................................ $60,967 Rebate of 6/7 of gross production tax paid on oil and gas produced from deep wells, horizontally drilled wells, and other special wells ............................................................ $57,000 Exclusion from income tax for up to $7,500 of most government retirement and Social Security benefits ...................................................................................................................... $50,215 Use tax on livestock brought into Oklahoma for eventual sale ............................................................ $48,049 Sales tax on advertising ............................................................................................................................. $46,794 Use tax on property to be used by airlines or railroads ........................................................................ $45,706 Credit for sales tax paid by individuals with gross income of less than $20,000 or families with less than $50,000 ............................................................................................. $37,813 Credit for income tax paid to another state on personal services income .......................................... $33,321 Income tax credit equal to 5 percent of federal earned income tax credit .......................................... $30,243 Nonrefundable income tax credit for an investment in depreciable property or to increase in employment .................................................................................................................... $28,680 Sales tax on food purchased with food stamps ...................................................................................... $20,731

personnel system, and comply with Merit System rules in the management, promotion, and termination of its employees. At June 30, 2007, agencies required to operate under the Merit System had 32,532 employees, of which 27,098 were in classified Merit System positions. Other state agencies employed 4,379 individuals. In addition, Oklahoma’s system of higher education operates outside Merit System regulations.

For the year ended June 30, 2007, the State experienced employee turnover of 13.2 percent.

For the ten-year period ended June 30, 2007, employee turnover ranged between 11.7 percent and 14.2 percent.

Other tax preferences may not be included because the Oklahoma Tax Commission does not calculate an estimate of the revenue impact or has determined that a meaningful estimated cannot be made. The Tax Expenditures Report is prepared by the Tax Policy Division of the Oklahoma Tax Commission and is available from the Commission.

Note 16. Commitments No significant change is contemplated.

Note 17. Litigation and Contingencies No significant change is contemplated.

Note 19. Subsequent Events No significant change is contemplated.

Note 18. Workforce Resources and Qualifications Most State agencies are required to hire new employees through the Merit System, a central 20

I L LU S T R AT I V E S TAT E M E N T S O F A C T I V I T I E S F O R E A C H A C T I V I T Y G R O U P I N G

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Education For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

Elementary and secondary education Higher education Vocational education Oklahoma Student Loan Authority School for the Deaf School for the Blind Other education

$ 5,069,833 3,793,083 270,965 67,045 9,481 6,479 8,542

$

(112,890) (3,165,217) (5,160) (60,391) (59) (41) (855)

$ 4,956,943 627,866 265,805 6,654 9,422 6,438 7,687

$ (599,803) (141,351) (18,328) (6,307) (4,310) (312)

$ 4,357,140 486,515 247,477 6,654 3,115 2,128 7,375

Total Education

$ 9,225,428

$ (3,344,613)

$ 5,880,815

$ (770,411)

$ 5,110,404

The accompanying notes are an integral part of the illustrative financial statements.

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Health and Welfare For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

Medicaid and related health services $ 3,878,686 Food Stamps program 610,366 Services and assistance to the aged, blind, and disabled 561,687 Child and family services 558,855 Mental health services 312,007 Day care assistance 227,817 Assistance to the unemployed 197,423 Oklahoma Housing Finance Authority 173,349 Disease prevention services 154,701 University Hospital Authority 146,784 Nursing care for veterans 113,455 Rehabilitation services 89,605 Temporary Assistance for Needy Families program 67,016 Oklahoma State University Medical Authority 33

$ (99,456) (20)

$ 3,779,230 610,346

$ (2,450,021) (564,243)

(89,350) (30,737) (27,574) (8,595) (6,687) (54,417) (11,102) (108,005) (36,146) (287)

472,337 528,118 284,433 219,222 190,736 118,932 143,599 38,779 77,309 89,318

(150,731) (197,481) (40,019) (35,785) (241,117) (126,215) (96,240) (39,171) (54,745)

321,606 330,637 244,414 183,437 (50,381) (7,283) 47,359 38,779 38,138 34,573

(56,086) -

6,607 (367)

Total health and welfare

$ (477,099)

$ 7,091,784

(4,323) (400)

62,693 (367) $ 6,614,685

The accompanying notes are an integral part of the illustrative financial statements.

21

$ (4,051,854)

$ 1,329,209 46,103

$ 2,562,831

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Public Safety For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

Punishment and rehabilitation of adult offenders $ 565,813 Disaster preparedness and response 153,414 Juvenile crime prevention and correction 143,419 Highway Patrol and related activities 123,515 Investigative and forensic services 108,597 District Attorney activities 82,018 Child support enforcement 72,716 Homeland security 52,889 Oklahoma National Guard 34,675 Criminal defense of indigent defendants 20,969 Law enforcement other than Highway Patrol 15,597 Domestic violence prevention, etc 10,173 Other public safety and defense activities 51,313

$ (42,901) (2,794) (1,158) (1,067) (26,475) (5,955) (3) (569) (2) (1,057) (1,397) (2,561)

$ 522,912 153,414 140,625 122,357 107,530 55,543 66,761 52,886 34,106 20,967 14,540 8,776 48,752

$

(4,835) (144,511) (15,514) (1,622) (3,479) (11,334) (40,169) (47,071) (21,205) (1,428) (2,223) (3,184) (6,887)

$ 518,077 8,903 125,111 120,735 104,051 44,209 26,592 5,815 12,901 19,539 12,317 5,592 41,865

Total public safety

$ (85,939)

$1,349,169

$ (303,462)

$1,045,707

$1,435,108

The accompanying notes are an integral part of the illustrative financial statements.

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Transportation For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

State highways and turnpikes Railroads Aeronautics Waterways

$ 912,293 10,457 3,377 2,259

$ (304,515) (1,380) (1,414) (289)

$ 607,778 9,077 1,963 1,970

$ (435,818) (6,378) (1,093) (1,338)

$ 171,960 2,699 870 632

Total transportation

$ 928,386

$ (307,598)

$ 620,788

$ (444,627)

$ 176,161

The accompanying notes are an integral part of the illustrative financial statements.

22

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Public Insurance For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

OSEEGIB* CompSource Health insurance high risk pool Multiple injury trust fund

$ 590,831 299,566 25,337 7,964

$ (602,576) (347,019) (25,270) (1,940)

$ (11,745) (47,453) 67 6,024

$

-

$ (11,745) (47,453) 67 6,024

Total public insurance

$ 923,698

$ (976,805)

$ (53,107)

$

-

$ (53,107)

* Oklahoma State and Education Employees Group Insurance Board The accompanying notes are an integral part of the illustrative financial statements.

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Public Utilities For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

Grand River Dam Authority Oklahoma Municipal Power Authority

$ 224,542 155,825

$ (314,287) (156,966)

$ (89,745) (1,141)

$

-

$ (89,745) (1,141)

Total public utilities

$ 380,367

$ (471,253)

$ (90,886)

$

-

$ (90,886)

The accompanying notes are an integral part of the illustrative financial statements.

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Assistance to Local Governments For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

County health services Community development County roads and bridges Police and firefighter pension costs

$ 122,256 100,259 71,099 35,296

$ (3,890) (249) -

$ 118,366 100,010 71,099 35,296

$ (78,066) (73,802) -

$ 40,300 26,208 71,099 35,296

Total assistance to local governments

$ 328,910

$ (4,139)

$324,771

$ (151,868)

$172,903

The accompanying notes are an integral part of the illustrative financial statements.

23

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Natural and Cultural Resources For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Operate state parks and golf courses $ 61,718 Wildlife and fisheries activities 48,470 Agriculture and food services 35,286 Conservation of water resources 27,170 Conservation and reclamation services 24,392 Okla Centennial Comm Fund 24,152 Oklahoma history programs 21,878 Forestry and fire fighting services 20,178 Reclaim well sites 14,507 Public television 14,125 Other natural and cultural resources activities 3,394

$ (26,821) (4,912) (4,593) (37,374) (72) (2,116) (3,102) (538) (4,289) (397)

$ 34,897 43,558 30,693 (10,204) 24,320 24,152 19,762 17,076 13,969 9,836 2,997

$

Total natural and cultural resources

$ (84,214)

$ 211,056

$ (107,909)

$ 295,270

(2,967) (24,002) (4,633) (14,232) (12,447) (21,701) (2,755) (4,731) (17,434) (2,485) (522)

Burden to taxpayers $ 31,930 19,556 26,060 (24,436) 11,873 2,451 17,007 12,345 (3,465) 7,351 2,475 $ 103,147

The accompanying notes are an integral part of the illustrative financial statements.

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for General Government For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

Judiciary Legislature Elections Governor Other general government

$ 107,564 35,754 8,938 3,507 4,086

$ (62,402) (575) (27) (260) (2,816)

$ 45,162 35,179 8,911 3,247 1,270

$ (4,587) (114) (10) (541)

$ 40,575 35,065 8,901 3,247 729

Total general government

$ 159,849

$ (66,080)

$ 93,769

$ (5,252)

$ 88,517

The accompanying notes are an integral part of the illustrative financial statements.

24

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Regulatory Activities For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Net expense

Grants and contributions

Burden to taxpayers

Regulation of businesses and professions Regulation of energy and environment Driver licensing Regulation of transportation Insurance regulation Workplace regulation Public utility regulation Regulation of retail fuel outlets Health services regulation Investment regulation

$ 23,159 18,651 18,514 14,414 11,495 8,738 5,840 5,584 5,545 4,728

$ (1,242) (695) (2,545) (715) (338) (41) (376) (40) (324) (197)

$ 21,917 17,956 15,969 13,699 11,157 8,697 5,464 5,544 5,221 4,531

$

(355) (1,725) (185) (784) (696) (1,609) (157) (1,407) -

$ 21,562 16,231 15,784 12,915 10,461 7,088 5,307 4,137 5,221 4,531

Total regulatory activities

$ 116,668

$ (6,513)

$ 110,155

$ (6,918)

$103,237

The accompanying notes are an integral part of the illustrative financial statements.

STATE OF OKLAHOMA Illustrative Cost-Focused Financial Statements Statement of Activities for Economic Development For the Fiscal Year Ended June 30, 2008 (in $ thousands) Expense

Sales

Business development Support of scientific research and development Promote Oklahoma tourism Training for Industry program Oklahoma Industrial Finance Authority Oklahoma Capital Investment Board Oklahoma Development Finance Authority Other economic development activities

$ 57,530 22,543 16,156 5,979 3,002 2,478 1,231 1,120

$

Total economic development

$ 110,039

$ (11,011)

Net expense

(82) (880) (1,208) (202) (3,089) (4,140) (1,347) (63)

The accompanying notes are an integral part of the illustrative financial statements.

25

Grants and contributions

Burden to taxpayers

$ 57,448 21,663 14,948 5,777 (87) (1,662) (116) 1,057

$ (3,082) (1,369) (725) (248)

$ 54,366 21,663 13,579 5,052 (87) (1,662) (116) 809

$ 99,028

$ (5,424)

$ 93,604

Tom Daxon is a Certified Public Accountant who holds both an undergraduate and a master’s degree from Oklahoma State University. In 1978, he was elected State Auditor and Inspector for Oklahoma. He inherited an office which had been placed on probation by the federal government and built it into one of recognized excellence. In his final year, Oklahoma became the first state to prepare and publish a comprehensive annual financial report using generally accepted accounting principles.

Following his tenure as Oklahoma’s Auditor and Inspector, Daxon became a principal with Arthur Andersen and advised government clients across the country. He led the research team that prepared pro forma financial statements for the U.S. Govern-

ment using accrual concepts.

In 1993, Daxon played a key role in stabilizing an office of the Resolution Trust Corporation that had been the subject of unfavorable national publicity, and the following year he was asked to serve as Treasurer of Orange County, California, following the County’s bankruptcy. Daxon organized and led a team of underwriters that was able to develop a successful strategy that repaid the County’s creditors, restored the County’s credit rating, and avoided raising taxes.

In 1995, Daxon returned to Oklahoma where he served as Secretary of Finance and Revenue for Gov. Frank Keating. He currently practices as a CPA in Oklahoma City and serves on a task force of the Federal Accounting Standards Advisory Board.

The author would like to thank his fellow CPA, Steven J. Anderson, for his invaluable assistance and counsel, and also like to thank the following students at Oklahoma Christian University who served as interns and compiled much of the data used in the report: Lauren Elise Jennings, Nathan Goodnight, Jeremiah A. McDaniel, Jonathan Niccum, Patrick Rayner, Michael A. Reese, and Rhea S. Swarb.

26

OCPA Trustees

OCPA Adjunct Scholars

OCPA Fellows Steven J. Anderson, MBA, CPA

Blake Arnold

Henry F. Kane

Oklahoma City

Will Clark, Ph.D.

Bartlesville

University of Oklahoma

J. Rufus Fears, Ph.D.

Mary Lou Avery

Robert Kane

David Deming, Ph.D.

Oklahoma City

Tulsa

University of Oklahoma

Dr. David and Ann Brown Distinguished Fellow for Freedom Enhancement

Lee J. Baxter

Tom H. McCasland III

Bobbie L. Foote, Ph.D.

Duncan

University of Oklahoma (Ret.)

David McLaughlin

Kyle Harper, Ph.D.

Lawton

Steve W. Beebe Duncan

John A. Brock Tulsa

David R. Brown, M.D.

Lew Meibergen

E. Scott Henley, Ph.D., J.D., D.Ph.

Research Fellow

Enid

Lloyd Noble II Tulsa

Aaron Burleson

Oklahoma City University (Ret.)

James E. Hibdon, Ph.D. University of Oklahoma (Ret.)

OCPA Staff

University of Central Oklahoma

Brett A. Magbee / VP for Operations Brandon Dutcher / VP for Policy Margaret Ann Morris / Director of Development Sandra Leaver / Event Coordinator Forrest Claunch / Operations and Special Projects Dacia Dodson / Executive Assistant Clara Wright / Receptionist

Andrew W. Lester, J.D.

Altus

Bill Price

Oklahoma City University (Adjunct)

Oklahoma City

Patrick Rooney

David L. May, Ph.D.

Oklahoma City

Ann Felton

Oklahoma City

Ronald L. Moomaw, Ph.D.

Melissa Sandefer

Oklahoma State University

Norman

Ann Nalley, Ph.D.

Oklahoma City University

Robert Sullivan

Cameron University

Tulsa

Bruce Newman, Ph.D.

Lew Ward

Western Oklahoma State College

Claremore

Enid

Stafford North, Ph.D.

John T. Hanes

William E. Warnock, Jr.

Oklahoma Christian University

Oklahoma City

Tulsa

Ralph Harvey

Gary W. Wilson, M.D.

Oklahoma City

Edmond

John A. Henry III

Daryl Woodard

Oklahoma City

Tulsa

OCPA Legal Counsel DeBee Gilchrist # Oklahoma City

Russell W. Jones, Ph.D.

Paul A. Cox

Kent Frizzell

Research Fellow

Wendy P. Warcholik, Ph.D.

Tulsa

Oklahoma City

Research Fellow

J. Scott Moody, M.A.

University of Oklahoma

Robert E. Patterson

Josephine Freede

Patrick B. McGuigan, M.A.

Enid

Oklahoma City

Oklahoma City

Research Fellow

Everett Piper, Ph.D. Oklahoma Wesleyan University

Michael Scaperlanda, J.D. University of Oklahoma

Andrew C. Spiropoulos, J.D. Oklahoma City University

The Oklahoma Council of Public Affairs, Inc. is an independent, nonprofit, nonpartisan research and educational organization devoted to improving the quality of life for all Oklahomans by promoting sound solutions to state and local policy questions. For more information on this policy paper or other OCPA publications, please contact:

1401 N. Lincoln Boulevard Oklahoma City, OK 73104 (405) 602-1667 • FAX: (405) 602-1238 www.ocpathink.org • ocpa@ocpathink.org